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Tuesday, March 24, 2009

Foreclosure and AIG

C. Northcote Parkinson said it best: (I paraphrase) the smaller the dollar value of a budgetary item, the more attention it gets from the decision makers. How true: we can all get our minds around the $150 million that were paid out in bonuses; we cannot begin to grasp the many trillions it may take to stabilize the banking system.

But focusing on the bonuses is a distraction from the main problem: the on going bailouts: There are two things wrong with the current approach: the wrong people are pursuing the wrong strategy.

Social Scientist have known for many years the problem of escalating commitment. Smart people commit funds to a project; the project turns out badly, so the smart people commit more funds to the same strategy in an attempt to recoup their losses. The men in charge of the current solution were in various ways associated with the roots of the problem. Larry Summers was instrumental in arguing for deregulation in the Clinton years; Tim Geithner, at the Federal Reserve Bank of New York, was responsible for the oversight of the institutions hat are collapsing around us. We need new minds to focus on the problem.

We also need a new approach. For every mortgage that is in trouble, there are many derivatives that hold a piece of that mortgage. But worse still, on each of those derivatives there are many, many insurance bets that have been made and that are held by AIG. There is not enough money in the universe to make AIG whole by taking those derivative derivatives off their hand. As Elizabeth Warren at a Harvard Public Meeting on the crisis said: Helping the Banks is looking at the wrong end of the dog. We need to look at the original mortgages. If they are made whole the pyramid of derivatives that rest on each of them will also be made whole. The way to do this is through the government entering into shared appreciation mortgages (SAMs) with the homeowner: the homeowners pay what they can, the government picks up the balance; both build up equity in the home which they will realize when the house is sold. This will be expensive. It has the advantages of simplicity: there is no need to unbundle complex derivatives; the mortgage handler simply goes on receiving the original income flow which is passed upstream to the derivative holders; the derivative holders are made whole. It keeps homeowners in their house; it keeps homeowners' children in their same schools; it maintains the stability of neighborhoods.

It will be expoensive and it will reward the good, the bad, the scoundrels, and the banks equally.

That will be a small price to pay to stop the disaster that faces us if we continue along the present path.

--Martin G. EvansProfessor Emeritus of Organizational BehaviourRotman School of Management